ESG Considerations for Securitized Fixed Neil Hohmann, PhD Managing Director Income Notes Head of Structured Products BBH Investment Management [email protected] +1.212.493.8017 Executive Summary Securitized assets make up over a quarter of the U.S. corporations since 2010, we find median price declines fixed income markets,1 yet assessments of environmental, for equity of those companies of -16%, and -3% median social, and governance (ESG) risks related to this sizable declines for their corporate bonds.3 Yet, the median price segment of the bond market are notably lacking. decline for securitized notes during these periods is 0% – securitized notes are as likely to climb in price as they are The purpose of this study is to bring securitized notes to fall in price, through these incidents. This should not be squarely into the realm of responsible investing through the surprising – securitizations are designed to insulate inves- development of a specialized ESG evaluation framework tors from corporate distress. They have a senior security for securitizations. To date, securitization has been notably interest in collateral, ring-fenced legal structures and absent from responsible investing discussions, probably further structural protections – all of which limit their owing to the variety of securitization types, their structural linkage to the originating company. However, we find that complexities and limited knowledge of the sector. Manag- a few securitization asset types, including whole business ers seem to either exclude securitizations from ESG securitizations and RMBS, can still bear substantial ESG assessment or lump them into their corporate exposures. risk. A specialized framework for securitizations is needed. A common presumption, given the lack of method, is that securitizations are at best neutral, and possibly a detractor We have developed an ESG evaluation framework, custom- from an ESG risk viewpoint. ized to these features of securitizations, in order to properly analyze their environmental, social, and governance We question that presumption. Analyzing the periods exposure. The framework has three pillars: surrounding the more severe ESG incidents2 at U.S. Pillars of the BBH ESG Evaluation Framework for Securitizations PILLAR 1 PILLAR 2 PILLAR 3 Identify and assess Analyze the underlying loan or Analyze the governance the nature and strength lease pool of the securitization integrity of the of all corporate linkages from an ESG perspective securitization trust Identify and assess linkages Any sizable concentration in the Analyze the securitization trust to a securitization (whether pool to a single loan borrower with (including the strength of its originator, servicer, or elevated ESG exposure may add standalone legal structure, guarantor). For each corporate further risk to a security. Such the clarity of cashflow rules, entity with a significant loan-related exposure may be the identity and role of the linkage to the trust, a separate mitigated, however, by a large independent trustee) from corporate ESG evaluation issuer equity position beneath the an ESG perspective. should be performed. securitized note or by structural protections in the transaction that accelerate repayment to noteholders if performance weakens. Once the risk exposure from each of these three pillars has been assessed, they can be aggregated into a single ESG risk measure for the entire trust. We provide an example of the application of this framework risk exposures for securitizations are generally low relative to a small-ticket asset-backed securitization (ABS) transac- to the range among unsecured corporate bonds. There are a tion. Using this framework, we then provide an overview of number of meaningful exceptions to this, however, strongly ESG factors and categorize their intensity across more than underscoring the need to apply a specialized ESG framework 30 sectors/subsectors of the securitization market. We find to securitized fixed income.4 that the environmental, social, and particularly governance 1 SIFMA, Outstanding Bond Market Debt 12/31/18. 2 Severe ESG events are tracked, analyzed and classified by ESG ratings and research provider Sustainalytics. 3 The better performance of corporate bonds versus equities during ESG incidents illustrates the mitigating effect of their more senior position. 4 Like securitizations, certain secured corporate bonds and loans also rely on dedicated security packages and structural protections to insulate from corporate ESG event risk. 1 1 Introduction Securitized notes and bonds are issued by standalone legal features of a securitization – its independent legal status, entities whose sole purpose is to purchase loan and lease bankruptcy remoteness, reliance on dedicated collateral, collateral pools, issue debt, and distribute interest and and structural mitigants. In our experience, it is important to principal cashflows to debtholders. They have limited (and recognize corporate linkages as part of any ESG assessment. in many cases no) linkage to operating companies. But such linkages should only be part of a broader ESG analysis that considers their relevance, the securitization’s The securitization market is diverse, spanning credit, agen- legal separateness and governance integrity, and the quality cy-backed, and government-guaranteed collateral types. and diversity of the underlying collateral pool. These include agency mortgage-backed securities (MBS), commercial mortgage-backed securities (CMBS), asset- An analyst of an auto loan ABS, for example, might consider backed securities (ABS), and collateralized loan obligations the corporate health of the auto lender as just one factor, and (CLOs). There are important commonalities. Securitized perhaps even a minor one, in the assessment of a credit. An bonds typically have an independent legal structure. They ESG assessment of this ABS should strive to place the risks benefit from the security of an underlying pool of loan and from governance failures at the auto lender in proper context lease assets. There are stringent, transparent rules for the with, say, any adverse social impacts from the auto loans distribution of collateral cashflows to noteholders, which are themselves, as well as the integrity of the note trust – its administered by an independent trustee. Finally, there are independence, stability, governance structure, and adminis- important structural protections for noteholders that can tration by a trustee. In addition, structural protections (like include equity and subordination beneath notes, sequential excess interest, subordination, and cashflow redirection in payment rules, and performance-related triggers to protect event of distress) can help ABS noteholders mitigate this noteholders in the event of collateral deterioration. combination of risks from corporate ties, the loan pool itself and the trust structure itself. These mitigants can help a Securitizations and Corporate Linkage securitization weather a severe ESG event that would devastate the originating company. For corporate equities and bonds issued by large public companies, ESG assessment is supported by large existing Appropriate ESG Framework databases of company benchmarks and an evolving body of ESG evaluation criteria. There is little practical guidance, Developing an appropriate ESG framework for securitizations however, on how to evaluate MBS, CMBS, ABS, and CLOs is no academic exercise. We demonstrate that the returns from an ESG perspective.5 One simple approach equates the for securitized notes during a severe ESG event are quite environmental, social and governance risk in a securitization different than for equity or corporate bonds. Simply tagging with the corporate ESG rating of the originating or servicing a securitization with the corporate ESG rating of its originator company. This approach erroneously treats a securitized note is not only misguided but rejected by empirical evidence. solely as a corporate obligation. It ignores all the distinctive 5 See, for example, CFA Institute, “Guidance and Case Studies for ESG Integration: Equities and Fixed Income.” Chapter “Fixed Income Case Studies: Structured Credit,” by Singer, McDonogh, Guo, and Reback of Angel Oak Capital Advisors. Their paper recognizes the practical difficulty of attaching a corporate ESG rating to each securitization trust without performing deeper due diligence into the securitization’s attributes. 2 2 Owning structured fixed income notes insulates investors from ESG event risk Independent structures, dedicated collateral, and structural The methodology of the analysis is described in the Appendix. mitigants tend to insulate securitized notes from the fallout of Daily return data was analyzed for companies that meet all of severe corporate ESG events at their originator or servicer. the following criteria: This is very clear when one compares the daily returns of a company’s securitized notes, through the course of a severe • Experienced an ESG incident of severity 5 or higher on ESG incident, to their corporate bond and equity returns. Sustainalytics’ severity scale. We examined the daily price returns of the equity, corporate • Had U.S. dollar public equity, corporate bonds, and securiti- bonds, and securitized bonds of the companies that experi- zations outstanding at the time of the incident. enced the most severe ESG incidents from 2010 to the • Had reliable daily price data available for all security types. present (the available length of the Controversies